Tax Lawyer Tip – What is Income Averaging and How is it Used by the IRS?

If the IRS is averaging your income, an Offer in Compromise may not be your best move.

If you suddenly find yourself in a situation where you owe the IRS back taxes, and the IRS has done everything except break down your front door, take a minute and learn about income averaging. It may give you the leverage to successfully negotiate more affordable payments on your back taxes.

“Income averaging,” when used by the IRS, means your current tax liability is calculated based on the average of your past income instead of your current earnings. This methodology is used to figure back taxes you owe if you are:

Self-employed

Earn your income from commissions

Have an unstable employment history

The IRS does not necessarily use income averaging in every single case. In many cases it works well because very often your past earnings are a great indicator of your future earnings. But since circumstances change, IRS revenue officers are allowed to use their judgment to determine if income averaging is appropriate. And, they may not always make the best decision.

Further, the IRS may also choose what it believes to be the appropriate time frame for averaging your income. If you are in a situation where you disagree with with the IRS’s determination, you will have to show why the determined time frame doesn’t accurately reflect your true earning potential.

If you are self-employed or if you earn your income from commissions, your earnings may vary widely throughout the year. You can effectively argue that a longer amount of time must be analyzed if you disagree with the earning potential the IRS determined.

Very often, if the IRS sees an increase in your current income, it will assume this earning potential will continue on into the future. You can counter this argument by demonstrating your historical income levels to the IRS. However, your argument will be much stronger if you can demonstrate why your current earnings are so high, and why this isn’t likely to continue into the future.

In the IRS is averaging your income, an Offer in Compromisemay not be your best strategy (it depends on your case).

In situations where you have an unstable employment history, the IRS typically uses a three-year average. If you have no income at all, you might be better off to pursue non-collectible status. This can be preferable in an averaging situation to an offer in compromise because non-collectible status is based on your current income, whereas an offer in compromise factors in future income. If you do choose to go with an offer in compromise, the average earnings history can work to your advantage, as the IRS often gets creative when determining your income.

Make sure to ask your tax lawyer to calculate your average income in relation to your current income. Don’t leave your tax case to guess work, consult an experiencedTax Attorneyto find the best path forward.